Are Banks Happy When Managers Go Long? The Information Content of Managers’ Vested Option Holdings for Loan Pricing

Traditional finance theory holds that managers with option-laden incentive contracts may favor equity at the expense of debt. However, once options vest, managers may directly influence the degree to which their personal fortunes are tied to their firms by deciding whether or not to exercise these options. We hypothesize that a risk-averse manager will retain a larger share of personal wealth in the form of vested in-the-money options when the manager has private information that the firm’s future performance will either be better or less risky. It follows that vested option holdings should be positively correlated with credit quality. In support of this, we find that vested option holdings have a strong negative association with loan pricing, especially for informationally sensitive loans. To investigate the underlying mechanism, we conduct a follow-on study of share price behavior. Our results suggest that vested option holdings have information content for lenders primarily by signaling lower risk in firm performance.